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Sunday, January 03, 2010

Exchange rate regime of systemically important countries

Many people believe that the exchange rate regime (i.e. the monetary policy regime) of each country is its own sovereign choice.

In the Great Depression, we saw the harmful effects of the exchange rate mercantalism that is feasible with fiat money. This was a key motivation for Keynes and others in their design of the post-war order. The IMF was supposed to be a multilateral body that would help bring pressure on countries to move towards good sense through `ruthless truth-telling'. This didn't work out too well. The IMF got itself into a box where it would not say anything about exchange rate regimes. To some extent, by standing ready to help countries that got into a currency crisis, it has helped perpetuate exchange rate pegging.

For the present discussion, I want to emphasise the distinction between small countries who can pretty much do as they like as opposed to systemically important countries where actions have a significant impact upon the world economy at large. In this approach, the four interesting questions are:

In the selfish maximisation of one country at a time, what is the optimal choice of monetary policy regime / exchange rate regime?

What the mechanisms and empirical magnitudes through which the exchange rate regime choice of one country imposes externalities on others? I.e. what is the consequence of the Nash equilibrium?

What is an ideal solution for the world, which combines optimality for the local economy with good system outcomes?

What international institutional arrangements can help push the system towards the right solution?

On the first question, some people believe that exchange rate mercantalism is good for the country. You don't find much of this amongst professional economists.. As Merton Miller said: If devaluations could make a country rich, Argentina would be the richest country in the world. For a careful rebuttal of this loose thinking, done by one of the world's top economists, see these discussant comments by Michael Woodford about a paper with this view by Dani Rodrik. As Andrew Rose said in a discussant comments at the Neemrana conference about a similar paper by Surjit Bhalla: This is either a home run or it's totally wrong.

I feel that exporting is great for growth, but only when this exporting involves genuinely facing the market test of the global market. If a country exports based on subsidies of some sort - which I term `fake exports' - then the gains in productivity and capability do not come about (link, link). My sense is that in China also, intellectuals no longer buy the `distort everything for exports' idea. Also see Lorenzo Bini Smaghi on this.

As with every other export-subsidy or protectionist scheme, this has more takers amongst non-economists than amongst economists. It's slow hard work, banging these down over and over.

On the third question, I have a comment on `global imbalances'. Some people see big numbers for current account surpluses/deficits as being intrinsically flawed. I look upon them as being the success of globalisation, as a repudiation of the Feldstein/Horioka problem. It is in an autarkic world that you see Feldstein/Horioka problems, where capital flows are not large. If we are to get beyond the Lucas paradox, and get back to the massive `development' capital flows of the First Globalisation, it's going to require large sustained BOP surpluses in some countries and deficits in others.

As an example, the best deal for ageing OECD is to buy securities in young countries like India today, thus spurring their growth today. Over the next 50 years, these securities would yield a flow of widgets back and thus support consumption of their elderly.

Hence, I would say the question is: How can the world be made safe for large BOP surpluses/deficits? This is a more interesting and important problem, instead of saying to ourselves: How can the world eliminate large BOP surpluses/deficits.

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